I think we can now call it a crisis.
Emerging market currencies continue to drop. The Indonesian rupiah sinks to its lowest level since 2009. The Indian rupee hits a new record low. The Turkish lira falls another 0.8% against the dollar. The Brazilian real drops to its lowest level since March 2009.
Central bank actions haven’t been able to stem the decline. The Reserve Bank of India said it will begin buying government bonds on August 23 and still the rupee fell. The central bank of Turkey announced that it would raise its overnight lending rate by 50 basis points and still the lira retreated.
And this was before today’s sell off in the U.S. markets after the release of minutes from the Federal Reserve’s Open Market Committee meeting on July 31. It’s unlikely that this sell off will push emerging markets up over night.
This all started, Stage 1, when speculation that the U.S. Federal Reserve would begin to taper off as early as September its $85 billion a month in purchases of U.S. Treasuries and mortgage-backed assets produced an increase in U.S. interest rates and a reversal of cash flows that had sent $1.2 trillion into emerging economies in 2012, according to figures from HSBC. However, in 2013, to take one example, $95 billion has flowed into U.S. ETFs and $8.4 billion has been withdrawn from emerging market exchange traded funds.
But we’ve now moved into Stage 2. Here the fear is that attempts to defend emerging market currencies will require central banks to raise interest rates, which would cut into economic growth rates that are already falling on a slowdown in growth in China. Many developing countries have, so far, chosen to defend their currencies by intervening in the markets to buy up their local currencies and/or sell dollars. That’s a viable option for countries like Brazil that have substantial reserves. But for other countries with less in foreign exchange reserves and big current account deficits that kind of intervention isn’t possible in the long term. Countries such as Turkey and Indonesia, for example, look like they’ll have to join India in pursuing a series of interest rate increases that will eat into economic growth.
Stage 3 doesn’t seem far away. In this next stage companies in developing economies that have built up big debt positions denominated in dollars— because dollar loans were much cheaper than loans in local currencies—will find it hard to repay those loans in much more expensive dollars. Turkey, for example, runs a current account deficit of about $55 billion a year—most of which has to be financed by cash flows from outside Turkey. Public and private sector external debt coming due in the next 12 months totals $163 billion.
That would be a big enough problem in this era when cash flows are headed out of emerging markets, but much of the debt at Turkish companies is denominated in dollars. Total dollar loans (which includes loans that aren’t due in the next 12 months) come to $172 billion or about 22% of the country’s GDP. That debt will get even more expensive if the lira continues to decline. Goldman Sachs project the currency will drop another 15% to 2.2 lira to the dollar from a recent 1.95 to the dollar
If Stage 3 produces a couple of big corporate debt defaults or restructurings, it will send emerging market equities down another step.
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